QBE Insurance and Macquarie Bank are incredible opportunities. So why do we recommend you allocate only a few percent of your portfolio to them?

‘Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock.’ – Warren Buffett, 1996 letter to shareholders.

QBE Insurance and Macquarie Group’s renowned brands, attractive economics and fine management make them excellent businesses. Both face short term difficulties but future earnings are likely to be substantially higher than today’s. Trading at very attractive prices, they’re both Strong Buy recommendations and two of our best investment ideas ever. If you were to follow Buffett’s advice, you’d be buying them with every skerrick of available capital—with ‘your ears pinned back’, as they say.

We’re not recommending that at all. Instead, we suggest you restrict QBE and Macquarie to just 7% and 5% of your portfolio respectively. How one reconciles our strongest recommendation with a modest portfolio limit is the subject of this Investor’s College.

Key Points

Stock picking and portfolio allocation are distinct tasks but both are central to successful investing

A cheaper stock doesn’t always deserve a higher weighting

Stick to recommended portfolio limits and consider recommendations in this light

Successful investors have two essential tasks. The first is to identify underpriced stocks, something in which Intelligent Investor assists you. The more positive—or stronger—our recommendation, the cheaper we believe a stock to be priced. For example, a stock with a Buy recommendation is cheaper than a stock assigned a Long Term Buy, and a Strong Buy suggests a stock is cheaper still.

Portfolio weightings

The second task is to assemble those stocks into a portfolio that’s appropriately structured according to your investing goals and risk profile. Our recommended maximum portfolio weightings should be central to this task.

There’s clearly a relationship between the two. Overpriced stocks shouldn’t be in your portfolio at all whilst mildly underpriced stocks might have small weightings. Everything else being equal, it makes sense for extremely underpriced stocks to have higher weightings.

But of course, everything isn’t equal. Consider Woolworths: Save a zombie apocalypse, it’s virtually certain to continue to make vast profits selling groceries. If it became sufficiently cheap we’d have little hesitation recommending it for up to 10% of your portfolio.

Insurers, on the other hand, are prone to high impact shocks; the September 11 terrorist attacks are perhaps the best example. Another such event would result in large claims and perhaps a capital raising. It’s a slim but real risk for QBE Insurance; the type of risk that Woolies simply doesn’t face.

Portfolio point

As well as portfolio limits on individual stocks, we recommend limiting your total portfolio exposure to banks to no more than 10% and no more than another 15% in other financials such as insurance companies and fund managers. Your total financial services sector portfolio limit should be no more than 25%. The more conservative you are, the lower these numbers should be.

Much the same argument applies to Macquarie Bank. It’s highly leveraged; one rogue trader could lose billions and, as a business far more complex than a simple food retailer, more can go wrong. Macquarie Group’s share price fall from its all-time high of $98.64 to its current price of $21.90 suggests as much.

Charts 1 and 2 offer a visual representation of this point. The more skewed the graph is to the right (showing a higher weighted probability of a good outcome), the cheaper the stock is and the more positive the recommendation will be. That’s why Macquarie and QBE carry Strong Buy recommendations and Woolworths only a Long Term Buy.

The wider the spread of possible outcomes, the greater the risk of a poor one, and the lower the portfolio limits should be. Macquarie and QBE’s portfolio weightings should be low while Woolies’ tighter range of potential outcomes and greater certainty permits a higher weighting, assuming the price is right.

So, whilst Macquarie and QBE are very cheap, these aren’t businesses about which one can be ‘virtually certain’ things will work out well. The portfolio limits offer an insurance policy in the event that they don’t.

Conviction indication

A strong recommendation with a relatively low portfolio limit—as is the case with QBE and Macquarie Bank—indicates a very cheap stock in an inherently risky industry. A strong recommendation with a relatively high portfolio limit indicates a far higher level of conviction, implying a cheap stock in a more stable and predictable industry.

The lesson is to use the two in combination, not isolation.

If you’re still not convinced, revisit our 2010 Analyst Interview videos, in particular those with Gareth Brown, Nathan Bell and Greg Hoffman. Listen to what they consider their biggest investing mistakes.

What to know more?

If you’re after more portfolio advice, we recommend reading our special report Building and managing a portfolio, which delves into these ideas in much greater depth.

It wasn’t that they were fully invested in 2007; It wasn’t that they didn’t buy more RHG or Flight Centre during the GFC; it was overconfidence. Each allocated too much money to what seemed like very cheap stocks that didn’t work out.

By sticking to portfolio limits and separating your stock picking and portfolio allocation decisions, you can avoid these costly mistakes.

Note: The model Growth portfolio owns shares in Macquarie Group and QBE, while the Income portfolio owns shares in QBE.

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